Inside the Rule of Thumb for Refinancing Your Mortgage

You have probably heard some version of a rule of thumb for refinancing your mortgage: for example, that you should be able to lower your interest rate by at least 0.75 percent before you consider refinancing.

That rule of thumb is useful, but it also has some limitations. Think of it as a starting point rather than a real decision rule, because there are actually five more detailed factors that going into determining whether or not refinancing makes sense for you.

Inside the Rule of Thumb: Thinking Through Refinancing Your Mortgage

The rule of thumb is based on an estimate of how much you would have to save in interest expense to overcome the upfront cost of refinancing. However, given how different every individual situation might be, a rule of thumb can only give you a rough idea of when it is worth it to thinking about refinancing. To take a deeper look inside the issue, here are five things to consider:

The rule only applies to fixed rate mortgages

Get this issue out of the way right up front: if you have an adjustable-rate mortgage, that rule of thumb does not apply to you. You should benefit automatically from lower interest rates when your mortgage resets, without the hurdle of refinancing costs. The only issue to consider in this case is whether you want to refinance to a fixed-rate mortgage to lock in low rates and stabilize your monthly payments.

Do the math to see the actual cost/benefit of refinancing

The math of whether you can save money by refinancing boils down to a comparison between how much it will cost up front to refinance and how much interest you would save month-to-month going forward. The problem is, closing costs can vary significantly from one lender to another, so no one rule of thumb always fits. Fortunately, refinancing calculators make it easy to crunch the numbers. Along with a refinancing rate quote, get an estimate of actual closing costs from a potential lender. Use a refinancing calculator to take a detailed look at how your closing costs would compare with your monthly savings.

Don't forget about prepayment penalties

Along with closing costs, another upfront hurdle in refinancing may be a penalty from your current lender for paying your mortgage off early. Look at the terms of your current loan to see if such a penalty would apply and how much it would be. Add that in along with your closing costs when you crunch the numbers in a mortgage calculator.

Breakeven time is critical

The tricky thing about comparing upfront refinancing costs with monthly interest savings is that they don't occur at the same time. Typically, you would incur the costs all at once while the interest savings are realized over time. This is important for two reasons. First, if you sell the house before the breakeven point where the savings match the upfront cost, you will never get to realize all the potential savings. So, if there is a possibility you might move within the foreseeable future, it is essential that you do a breakeven analysis before refinancing. The second reason knowing the breakeven point is important is that if it is many years in the future, the loss of potential earnings in the meantime on money you had to shell out upfront might negate the eventual interest savings. A good way to account for this is to look at the payment comparison as if you were financing the upfront costs (i.e., including them in the new mortgage) to see if those costs plus the interest associated with them would wipe out any interest rate savings from refinancing.

There are other reasons to refinance

Finally, while having a rule of thumb might help you spot opportunities to save on interest, don't be trapped by that rule. There are other reasons to refinance, such as to stretch the remainder of the loan out over a longer period of time to make monthly payments more affordable.

Thinking about the rule of thumb as a starting point rather than a decision rule is actually liberating. It frees you from trying to figure out whether 0.75 percent or 1 percent or 1.25 percent is the best rule of thumb to use. The best advice is to set the rule of thumb on the low side, say at 0.75 percent, and use that as an alert for when it makes sense to take a more detailed look at the question.